Letters of intent are handy road maps in M&A

Some regard a letter of intent, or LOI, as merely an “agreement to agree.”

But, a letter of intent is the first opportunity for a buyer and seller to formally negotiate the terms of a merger or acquisition, and knowing what to say and how to say it is an important first step toward a smooth, efficient and ultimately successful deal.

The binding provisions of an LOI should provide the buyer with the assurances it needs to commit significant time and resources to the transaction, while offering the seller comfort that it only will need to remain engaged with the buyer for a finite period of time before seeking another suitor.

In addition, a well-drafted letter of intent establishes the economic and legal fundamentals of the deal and, since most of the provisions of an LOI are non-binding, creates a “moral” obligation between the parties that can be used as leverage during subsequent negotiations.

If the parties have entered into a separate confidentiality agreement, then exclusivity and allocation of fees and expenses are typically the only notable binding provisions in an LOI. While the scope of exclusivity is usually not heavily negotiated, the duration of the exclusivity period is. Buyers continue to be cautious during due diligence, and an exclusivity period of 60 to 90 days is common in the context of the sale of a private company.

While the arguments in favor of a shorter or longer exclusivity period are fairly obvious, the positions that a buyer and seller take while negotiating exclusivity can provide valuable insight into the psychology of the parties. For example, I recently represented a bidder that requested a 90-day exclusivity period. When pressed by the seller's investment banker, the bidder indicated it would not start legal and accounting due diligence until it had completed a quality of earnings analysis and that it would need the full 90 days to complete due diligence. The seller was not comfortable with this timeline and elected to move forward with other bidders.

Conversely, a bidder in a recent sell-side engagement indicated that it could complete all due diligence in 30 days. The seller did not find this timeline to be credible and discounted the bid accordingly. In both cases, the exclusivity negotiations provided insight into the expectations of the parties.

When it comes to the non-binding provisions of an LOI, the details involve more art than science. A basic description of the structure of the transaction, the form and amount of the purchase price and an express statement regarding which provisions are binding are a given.

The LOI also presents an opportunity to anticipate issues that may arise during negotiations. By accelerating negotiations on these key points, a detailed LOI can help avoid disputes late in the sale process, when the parties may develop “deal fatigue” and negotiations often become heated. Issues to consider addressing specifically include escrow requirements, non-compete/non-solicit covenants, employment arrangements for key management (including the sellers), closing conditions and the fundamentals of the indemnification package (for example, survival periods, cap, basket, minimum claim threshold, etc.).

In my experience, the bigger the difference in the relative sophistication of the parties, the greater the benefit to having a detailed LOI. For example, the sellers in a recent middle-market private equity transaction objected to our client's detailed recitation of the indemnification package in the LOI. While the sellers indicated that they agreed with most of what was being offered, they requested that we defer these discussions.

When pressed to comment on our proposal, the sellers took several positions that were unacceptable to our client. The parties were ultimately able to resolve all of the open issues, but the LOI successfully identified these issues in a timely and efficient manner.

When done properly, the LOI can serve as a road map for the entire transaction and prove to be much more than time and money wasted on a piece of paper that is merely an “agreement to agree.”

Tony Kuhel is a partner in Thompson Hine's Corporate Transactions & Securities practice group and is vice chair of the practice in Cleveland. He focuses his practice on mergers and acquisitions, private equity and venture capital transactions.